May investment strategy - Economies begin to emerge

The speed of the post lockdown recovery will be partly dependent on how the “saving overhang” is spent.

Policies can help spur household confidence, but whether our economies generate structural unemployment as some sectors face lasting damage, will be key.

This will also be reflected in markets. Dispersion in equity markets has already been driven by “winners” and “losers” from the COVID-19 crisis.

We are confident that policy will continue to support high quality bond markets. Risk assets performance depends on policy, the dynamics of recovery and the prospects of a longer-term solution to virus management.

The fate of the saving overhang

A very specific characteristic of the current recession is that, at least in advanced economies, income – massively protected by fiscal policy – is falling much less than consumption. This is generating a very significant saving overhang. This is reflected in the Euro area by the record rise in households’ bank deposits in March (EUR75bn). The quality of the post-lockdown recovery will depend to a large extent on the speed at which this “forced saving” is spent.

It is tempting to look at China, which exited from lockdown much earlier than the Western countries, for guidance. There, it seems consumer spending has been quite subdued so far. But China is an exception among the key economies, since income fell quite significantly during the lockdown phase as Beijing refrained from the kind of all out fiscal packages seen in the West.

We would lay out three conditions for forced saving not to turn into precautionary saving.

First, families must be reasonably confident that the level of fiscal support they will receive will remain massive well after the end of the pandemic. From this point of view, the recent leaks in the UK according to which the Treasury is already discussing what tax hikes and spending cuts will be needed to ensure public debt sustainability is a perfect example of what should not happen. This would be a “Ricardian equivalence”[1] festival, since households would be incentivised to hoard the current handouts in preparation for future austerity. This issue could also come to the fore in the US as elections loom, reducing the scope for bi-partisan deals on further stimulus.

Second, financial markets must remain supportive. This is obviously related to the first condition – markets would respond positively to strong signals of a rebound in consumer demand – but a lot will also depend on the capacity of monetary policy to support the fiscal effort. We are not worried about this in the US and the UK. This is less assured in the Euro area given the specific institutional constraints on European Central Bank (ECB) action. However, we want to be cautiously optimistic after the Franco-German initiative which – if endorsed by the other members – could relieve the pressure on the central bank by building a proper fiscal mutualisation capacity.

Third, the nature of the labour market shock will be key. We can probably expect a wave of “re-hiring” after the lockdown in the US, while in Europe “subsidised employment” will naturally give way to “self-sustained jobs”. But some businesses will continue to suffer well after the peak in the pandemic. It is possible some sectors will be affected by lasting changes, e.g. transport, tourism or hospitality in general, conducive to a skills’ mismatch in the labour market. There is thus a clear risk that what is for now merely “cyclical unemployment” turns into “structural unemployment”, with a lasting adverse effect on consumer confidence.

It is quite possible that upon exiting the worst of the lockdown, some economic data and among them those pertaining to consumer spending rebound spectacularly, which would fuel market positivity. But we would advise to take some time to “gauge the damage” and check if such a rebound does not give way to a very cautious attitude towards spending. Reading real time economic data is challenging now. We need to take our time.

Inputs to investor confidence

In thinking about investment strategy, the near-term expected bounce in some of the high-frequency data is likely to improve investor sentiment. Data will suggest the worst of the economic downturn is behind us. Again, we need to be cautious as the medium-term outlook for economic recovery remains uncertain. US Federal Reserve (Fed) Chairman Jerome Powell recently said that the US economy would not fully recover until 2021. If recovery means attaining the same level of GDP that the US reached at the peak of the expansion before Q1 2020, this is optimistic. In the last recession, it took eight quarters from the trough in growth in Q1 2009 for GDP to return to its previous Q4 2007 peak.

Better short-term data prints are a necessary but not sufficient condition for a continued constructive view on risk assets. Ongoing evidence of a global peak in COVID-19 infections is another. Following the 2009 recession, recovery was held back by weak balance sheets and the credit crunch. Today the pace of recovery will be determined to a large extent by how quickly lockdowns are lifted and economic behaviours normalise. Successful management of this is also key to building investor confidence in credit and equities. Any suggestion that too rapid a loosening of social distancing guidance is leading to renewed spikes in infections will be bad news for markets.

We are positive that policy settings can remain in place for some time. This is important for the continued orderly functioning of money and credit markets. Core government bonds and investment grade credit are the asset classes most directly benefitting from the policy framework, with credit likely to continue to generate positive excess returns over coming months.

The policy framework is fundamental to the outlook for all asset classes to the extent that it will help determine the strength and timing of the recovery. However, there are two other vectors that are important – the longer-term management of the virus threat and the potential for sustained changes in the economic paradigm. Positive news on a vaccine and anti-viral testing is met with better stock market performance and the deployment of a successfully tested vaccine over the next year would certainly reduce the risk of rolling bear markets driven by recurring health and economic fears.

Equity markets appear to be reflecting the balance of positive news and look set to achieve previous highs long before they did after the 2009 downturn. This may be unnerving to many investors given the near-term earnings outlook and market level valuations. However, markets are also presenting a huge dispersion of performance. This is vividly illustrated by the growth-value gap and differences in performance between sectors that reflect the most COVID-19 damaged parts of economies and those that are reflecting changing business trends. Any set-back in risk appetite or more confidence on a traditional cyclical recovery could drive the growth-value gap lower again, but the legacy of the changes enforced by COVID-19 and opportunities created by that may continue to support the dominance of growth over the medium-term.

[1] Ricardian equivalence is a theory suggesting households anticipate future government financing needs and adjust their savings accordingly, reducing current spending and negating the boost from increased government spending.

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